%%FF148026_700
CHAPTER 18
M U L T I N AT I O N A L F I N A N C I A L
MANAGEMENT1
Q Sarah Jones/Masterfile
1
This chapter was coauthored by Professors Roy Crum of the University of Florida and Subu Venkataraman of Northwestern University.
%%FF148026_701
From the end of World War II until the
1970s, the United States dominated the
world economy, but that situation no
longer exists. Raw materials, finished
goods, services, and money flow freely
U.S. FIRMS
LOOK
OVERSEAS TO
ENHANCE
SHAREHOLDER
VALUE
across most national boundaries, as do
At the same time, foreign-based
multinationals are arriving on American
shores in ever greater numbers. Sweden’s ABB, the Netherlands’s Philips,
France’s Thomson, and Japan’s Fujitsu
and Honda are all waging campaigns to
innovative ideas and new technologies. World-class
be identified as American companies that employ
U.S. companies are making breakthroughs in foreign
Americans, transfer technology to America, and help the
labs, obtaining capital from foreign investors, and putting
U.S. trade balance and overall economic health. Few
foreign employees on the fast track to the top. Dozens
Americans know or care that Thomson owns the RCA and
of top U.S. manufacturers, including Dow Chemical,
General Electric names in consumer electronics or that
Colgate-Palmolive, Gillette, Hewlett-Packard, and Xerox,
Philips owns Magnavox.
sell more of their products outside the United States than
The emergence of “world companies” raises a host of
they do at home. Service firms are not far behind, as
questions for governments seeking to shape their nations’
Citicorp, Disney, McDonald’s, and Time Warner all
economic destinies. For example, should domestic firms be
receive more than 20 percent of their revenues from for-
favored, or does it make no difference what a company’s
eign sales.
nationality is as long as it provides domestic jobs? Should a
The trend is even more pronounced in profits. In
company make an effort to keep jobs in its home country, or
recent years, Coca-Cola and many other companies have
should it produce where total production costs are lowest?
made more money in the Pacific Rim and western Europe
What nation controls the technology developed by a multi-
than in the United States. As U.S. companies begin to
national corporation, particularly if the technology can be
reap half or more of their sales and profits from abroad,
used in military applications? What obligations does a multi-
they are finding it useful to blend into the foreign land-
national company headquartered in a given country have to
scape in order to win product acceptance and avoid politi-
adhere to rules imposed by its home country with respect to
cal problems.
its operations outside the home country? And if a U.S. firm
%%FF148026_702
such as Xerox produces copiers in Japan and then ships
them to the United States, should they be reflected in the
trade deficit in the same way as Toyotas imported from
Japan? Keep these questions in mind as you read this
LECTURE NOTE
Most large firms now compete in
a global market rather than in a
domestic market. Given the global
nature of business operations, it is
important to identify the factors
that distinguish multinational
business.
chapter. At the end, you should have a better appreciation
of both the problems facing governments and the difficult
but profitable opportunities facing financial managers of
multinational companies.
Managers of multinational companies must deal with a wide range of issues that
are not present when a company operates in a single country. In this chapter, we
highlight the key differences between multinational and domestic corporations,
and we discuss the impact these differences have on the financial management
of multinational businesses.
MULTINATIONAL, OR GLOBAL, CORPORATIONS
Multinational, or Global,
Corporation
A firm that operates in an integrated fashion in a number of
countries.
Slides 18-1, 18-2
The term multinational, or global, corporation is used to describe a firm that
operates in an integrated fashion in a number of countries. During the period
since World War II, a new and fundamentally different form of international commercial activity has developed, and this has greatly increased worldwide economic
and political interdependence. Rather than merely buying resources from and
selling goods in foreign nations, multinational firms now make direct investments
in fully integrated operations, from extraction of raw materials, through the
manufacturing process, to distribution to consumers throughout the world. Today, multinational corporate networks control a large and growing share of the
world’s technological, marketing, and productive resources.
Companies, both U.S. and foreign, go “global” for six primary reasons:
TM 18-1
1. To seek new markets. After a company has saturated its home market, growth
opportunities are often better in foreign markets. Thus, such homegrown
firms as Coca-Cola and McDonald’s are aggressively expanding into overseas
markets, and foreign firms such as Sony and Toshiba now dominate the U.S.
consumer electronics market.
Slide 18-3
2. To seek raw materials. Many U.S. oil companies, such as Exxon, have major
subsidiaries around the world to ensure access to the basic resources needed
to sustain the companies’ primary business line.
3. To seek new technology. No single nation holds a commanding advantage in
all technologies, so companies are scouring the globe for leading scientific
and design ideas. For example, Xerox has introduced more than 80 different
office copiers in the United States that were engineered and built by its Japanese joint venture, Fuji Xerox. Similarly, versions of the superconcentrated
detergent that Procter & Gamble first formulated in Japan in response to a
rival’s product are now being marketed under the Ariel name in Europe and
under the Cheer and Tide labels in the United States.
4. To seek production efficiency. Companies in high-cost countries are shifting
production to low-cost countries. For example, GE has production and assembly plants in Mexico, South Korea, and Singapore, and even Japanese manufacturers are shifting some of their production to lower-cost countries in the
Pacific Rim. Even BMW and Mercedes-Benz, in response to high production
costs in Germany, have built assembly plants in the United States. The ability to
shift production from country to country has important implications for labor
costs in all countries. For example, when Xerox threatened to move its copier
702
%%FF148026_703
MULTINATIONAL, OR GLOBAL, CORPORATIONS
703
rebuilding work to Mexico, its union in Rochester agreed to work rule changes
and productivity improvements that kept the operation in the United States.
Some multinational companies make decisions almost daily on where to shift
production. When Dow Chemical saw European demand for a certain solvent
declining, the company scaled back production at a German plant and shifted
its production to another chemical which had previously been imported from
the United States. Relying on complex computer models for making such decisions, Dow runs its plants at peak capacity and thus keeps capital costs down.
5. To avoid political and regulatory hurdles. The primary reason Japanese auto
companies moved production to the United States was to get around U.S. import quotas. Now Honda, Nissan, Toyota, Mazda, and Mitsubishi are all assembling automobiles or trucks in the United States. One of the factors that
prompted U.S. pharmaceutical maker SmithKline and Britain’s Beecham to
merge was that they wanted to avoid licensing and regulatory delays in their
largest markets, Western Europe and the United States. Now SmithKline Beecham can identify itself as an inside player in both Europe and the
United States. Similarly, when Germany’s BASF launched biotechnology research at home, it confronted legal and political challenges from the environmentally conscious Green movement. In response, BASF shifted its cancer and
immune system research to two laboratories in Boston suburbs. This location
is attractive not only because of its large number of engineers and scientists
but also because the Boston area has better resolved controversies involving
safety, animal rights, and the environment. “We decided it would be better to
have the laboratories located where we have fewer insecurities about what will
happen in the future,” said Rolf-Dieter Acker, BASF’s director of biotechnology research.
LECTURE NOTE
In earlier chapters, the advantages of diversification were addressed. Point out here that by
diversifying internationally, firms
can reduce their risk below what
is possible by relying on domestic
diversification. Put another way,
market risk can be reduced by
investing in global markets.
LECTURE NOTE
Although the firm can reduce risk
by diversifying internationally,
investors can achieve the same
result by purchasing foreign
securities.
FOR DISCUSSION
Ask whether companies’ crossborder investments lead to reduced likelihood of military conflict. The discussion can then be
led into the question of whether
we should encourage investment
in China and North Korea.
6. To diversify. By establishing worldwide production facilities and markets, firms
can cushion the impact of adverse economic trends in any single country. For
example, General Motors softened the blow of poor sales in the United States
during the 1990–1991 recession with strong sales by its European subsidiaries. In general, geographic diversification works because the economic ups
and downs of different countries are not perfectly correlated. Therefore, companies investing overseas benefit from diversification in the same way that
individuals benefit from investing globally.
Over the past 10 to 15 years, there has been an increasing amount of investment in the United States by foreign corporations, and in foreign nations by U.S.
corporations. This trend is shown in Figure 18-1, and it is important because of
its implications for eroding the traditional doctrine of independence and
self-reliance that has been a hallmark of U.S. policy. Just as U.S. corporations
with extensive overseas operations are said to use their economic power to exert
substantial economic and political influence over host governments in many parts
of the world, it is feared that foreign corporations are gaining similar sway over
U.S. policy. These developments suggest an increasing degree of mutual influence and interdependence among business enterprises and nations, to which the
United States is not immune.
The world economy is quite fluid. Here are a few of the recent events which
have dramatically changed the international financial environment:
1. The disintegration of the former Soviet Union and the movement toward market economies in the newly formed countries have created a vast new market
for international commerce.
%%FF148026_704
704
CHAPTER 18
F I G U R E
MULTINATIONAL FINANCIAL MANAGEMENT
1 8 - 1
D irect Inv e st ment for t he Unit e d St at es, 1982–1995
Dollars
(Billions)
800
700
600
500
400
300
200
100
0
1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995
Year
U.S. Direct Investment Abroad
Foreign Direct Investment
in the United States
SOURCE: J. Lowe and S. Vargas, “Direct Investment Positions on a Historical Cost Basis,” Survey of
Current Business, July 1996.
2. The reunification of Germany, coupled with the collapse of communism in
Eastern Europe, has created significant new opportunities for foreign investment.
ON THE WWW
The passage of NAFTA (North
American Free Trade Agreement)
ensures that continued international investment will be made
by U.S. corporations. An interesting January 1997 article about
the impact of NAFTA on the U.S.
economy can be found on the
United States Trade Representative’s Homepage at http://
www.ustr.gov/agreements/nafta/
information/econ.html. Detailed
information on NAFTA can be
found on the U.S. Department of
Commerce’s NAFTA Home Page at
http://iepnt1.itaiep.doc.gov/nafta/
nafta2.htm.
3. The European Community and the European Free Trade Association have created a “borderless” region where people, capital, goods, and services move
freely among the 19 nations without the burden of tariffs. Negotiations are
also under way to create a single “Eurocurrency,” which would greatly simplify economic exchange among the participating countries.
4. The North American Free Trade Agreement (NAFTA) has moved the economies of the United States, Canada, and Mexico much closer together, and made
them more interdependent.
5. U.S. bank regulations have been loosened dramatically. One key deregulatory
feature was the removal of interest rate ceilings, thus allowing banks to attract foreign deposits by raising rates. Another key feature was the removal of
barriers to entry by foreign banks, which resulted in more cross-border banking transactions. Still, U.S. commercial and investment banks do not have as
much freedom as foreign banks, which has led many U.S. banks to establish
subsidiaries in Europe that can offer a wider range of services, hence increase
global competition in the financial services industry.
%%FF148026_705
MULTINATIONAL VERSUS DOMESTIC FINANCIAL MANAGEMENT
705
SELF-TEST QUESTIONS
What is a multinational corporation?
Why do companies “go global”?
MULTINATIONAL VERSUS
DOMESTIC FINANCIAL MANAGEMENT
Slide 18-4
In theory, the concepts and procedures discussed in the first 17 chapters are valid
for both domestic and multinational operations. However, six major factors distinguish financial management in firms operating entirely within a single country from firms that operate globally:
TM 18-2
1. Different currency denominations. Cash flows in various parts of a multinational corporate system will be denominated in different currencies. Hence,
an analysis of exchange rates must be included in all financial analyses.
2. Economic and legal ramifications. Each country has its own unique economic
and legal systems, and these differences can cause significant problems when
a corporation tries to coordinate and control the worldwide operations of its
subsidiaries. For example, differences in tax laws among countries can cause
a given economic transaction to have strikingly different after-tax consequences, depending on where the transaction occurred. Similarly, differences
in legal systems of host nations, such as the Common Law of Great Britain
versus the French Civil Law, complicate matters ranging from the simple recording of business transactions to the role played by the judiciary in resolving conflicts. Such differences can restrict multinational corporations’ flexibility in deploying resources, and can even make procedures that are required
in one part of the company illegal in another part. These differences also make
it difficult for executives trained in one country to operate effectively in
another.
3. Language differences. The ability to communicate is critical in all business
transactions, and here U.S. citizens are often at a disadvantage because we
are generally fluent only in English, while European and Japanese businesspeople are usually fluent in several languages, including English. Thus, they
can invade our markets more easily than we can penetrate theirs.
IN THE REAL WORLD
Most business schools find that,
all else equal, their bilingual
graduates are more marketable
than those with only one language. Therefore, many faculty
will encourage their students
and advisees to include foreign
language courses in their
curriculum.
EXTRA EXAMPLE
Another example of politics influencing business is trade sanctions
imposed on countries as a result
of human rights violations. Under
such sanctions, firms are restricted
or prohibited from doing business
in the offending countries.
4. Cultural differences. Even within geographic regions that are considered relatively homogeneous, different countries have unique cultural heritages that
shape values and influence the conduct of business. Multinational corporations find that matters such as defining the appropriate goals of the firm, attitudes toward risk, dealings with employees, and the ability to curtail unprofitable operations vary dramatically from one country to the next.
5. Role of governments. Most financial models assume the existence of a competitive marketplace in which the terms of trade are determined by the participants. The government, through its power to establish basic ground rules,
is involved in the process, but its role is minimal. Thus, the market provides
the primary barometer of success and the best clues about what must be done
to remain competitive. This view of the process is reasonably correct for the
United States and Western Europe, but it does not accurately describe the
%%FF148026_706
706
CHAPTER 18
MULTINATIONAL FINANCIAL MANAGEMENT
situation in most of the world. Frequently, the terms under which companies
compete, the actions that must be taken or avoided, and the terms of trade
on various transactions are determined not in the marketplace but by direct
negotiation between the host government and the multinational corporation.
This is essentially a political process, and it must be treated as such. Thus,
our traditional financial models have to be recast to include political and other
noneconomic aspects of the decision.
6. Political risk. A nation is free to place constraints on the transfer of corporate resources and even to expropriate without compensation assets within
their boundaries. This is political risk, and it tends to be largely a given rather
than a variable that can be changed by negotiation. Political risk varies from
country to country, and it must be addressed explicitly in any financial analysis. Another aspect of political risk is terrorism against U.S. firms or executives. For example, U.S. and Japanese executives have been kidnapped and held
for ransom in several South American countries.
These six factors complicate financial management, and they increase the risks
faced by multinational firms. However, prospects for high profits, diversification
benefits, and other factors make it worthwhile for firms to accept these risks and
learn how to manage them.
SELF-TEST QUESTION
Identify and briefly discuss six major factors that complicate financial management in multinational firms.
Slide 18-5
Exchange Rate
The number of units of a given
currency that can be purchased
for one unit of another currency.
Slides 18-6, 18-7
ON THE WWW
The Bloomberg World Currency
Values site provides up-to-theminute foreign currency values
versus the U.S. dollar, as well as a
cross-currency table similar to
that found in The Wall Street
Journal for the world’s major currencies. The site can be accessed
at http://www.bloomberg.com/
markets/wcv.html.
IN THE REAL WORLD
The fact that currencies around
the world are quoted in U.S. dollars underscores that the dollar
has become as close to a world
currency as there is.
EXCHANGE RATES
An exchange rate specifies the number of units of a given currency that can be
purchased with one unit of another currency. Exchange rates appear in the financial sections of newspapers each day. Selected rates from a recent issue of
The Wall Street Journal are given in Table 18-1. The values shown in Column 1
are the number of U.S. dollars required to purchase one unit of foreign currency;
this is called a direct quotation. Direct quotations have a dollar sign in their quotation. Thus, the direct U.S. dollar quotation for the German mark is $0.6418,
because one German mark could be bought for 64.18 cents. The exchange rates
given in Column 2 represent the number of units of foreign currency that can
be purchased for one U.S. dollar; these are called indirect quotations. Indirect
quotations often begin with the foreign currency’s equivalent to the dollar sign.
Thus, the indirect quotation for the German mark is M1.5581. (The “M” stands
for Mark, and it is equivalent to the symbol “$.”) Normal practice in the United
States is to use indirect quotations (Column 2) for all currencies other than British pounds, for which direct quotations are given. Thus, we speak of the pound
as “selling at $1.67” but of the mark as “being at 1.56.”
It is also a universal convention on the world’s foreign currency exchanges to
state all exchange rates except British pounds on a “dollar basis” — that is, as
the foreign currency price of one U.S. dollar as reported in Column 2 of Table
18-1. Thus, in all currency trading centers, whether in New York, Frankfurt, London, Tokyo, or anywhere else, the exchange rate for the German mark would be
displayed as M1.5581. This convention eliminates confusion when comparing
quotations from one trading center with those from another.
%%FF148026_707
EXCHANGE RATES
T A B L E
1 8 - 1
707
Illustra t iv e Ex c hange Rat es
DIRECT QUOTATION:
U.S. DOLLARS REQUIRED
TO BUY ONE UNIT OF
FOREIGN CURRENCY
(1)
INDIRECT QUOTATION:
NUMBER OF UNITS
OF FOREIGN CURRENCY
PER U.S. DOLLAR
(2)
British pound
$1.6650
0.6006
Canadian dollar
0.7315
1.3671
Dutch guilder
0.5736
1.7435
French franc
0.1902
5.2575
German mark
0.6418
Italian lira
0.0006523
1,533.0000
1.5581
Japanse yen
0.008769
114.0400
Mexican peso
0.12726
7.8580
Spanish peseta
0.007634
130.9900
Swiss franc
0.7465
1.3395
NOTE: Column 2 equals 1.0 divided by Column 1. However, rounding differences do occur.
SOURCE: The Wall Street Journal, December 20, 1996.
TM 18-3
Slide 18-8
LECTURE NOTE
One way to help students learn
how to compute cross rates is to
point out that when rates are
written as fractions, the usual
rules of algebra apply. For example, to achieve the exchange
between pounds and francs, the
equation is written as dollars/
pounds 3 francs/dollars. The dollars in the numerator of the first
term cancel with the dollars in
the denominator of the second
term to yield francs/pounds.
We can use the data in Table 18-1 to show how one works with exchange rates.
Suppose a U.S. tourist on holiday flies from New York to London, then to Paris,
then on to Munich, and finally back to New York. When she arrives at London’s
Heathrow Airport, she goes to the bank to check the foreign exchange listing.
The rate she observes for U.S. dollars is $1.6650; this means that £1 will cost her
$1.6650. Assume that she exchanges $2,000 for $2,000/$1.6650 5 £1,201.20 and
enjoys a week’s vacation in London, spending £701.20 while there.
At the end of the week she travels to Dover to catch the Hovercraft to Calais
on the coast of France and realizes that she needs to exchange her 500 remaining British pounds for French francs. However, what she sees on the board is the
direct quotation between pounds and dollars ($1.6650) and the indirect quotation between francs and dollars (FF5.2575). (For our purposes, we assume that
the exchange rates in effect at the start of the trip remain in effect throughout
our example. This is unrealistic for reasons explained later in this chapter.) The
exchange rate between any two currencies is called a cross rate. Cross rates are
actually calculated on the basis of various currencies relative to the U.S. dollar.
For example, the cross rate between British pounds and French francs is computed as follows:
Cross rate 5
Francs
Francs
Dollars
3
5
Pound
Dollar
Pound
5 1.6650 dollars per pound 3 5.2575 francs per dollar
5 8.7537 francs per pound.
Therefore, for every British pound she would receive 8.7537 French francs, so
she would receive 8.7537 3 500 5 4,376.87 ' 4,377 francs.
%%FF148026_708
708
CHAPTER 18
MULTINATIONAL FINANCIAL MANAGEMENT
Slides 18-9, 18-10
When she finishes touring in France and arrives in Germany, she again needs
to determine a cross rate, this time between French francs and German marks.
The dollar-basis quotes she sees, as shown in Table 18-1, are FF5.2575 per dollar
and M1.5581 per dollar. To find the cross rate, she must divide the two dollarbasis rates:
Marks
Marks
Dollar
5
Cross rate 5
Franc
Francs
Dollar
TM 18-4
5
M1.5581 per $
5 0.2964 marks per franc.
FF5.2575 per $
Then, if she had FF3,000 remaining, she could exchange them for 0.2964 3
3,000 5 M889.20, or about 889 marks.
Finally, when her vacation ends and she returns to New York, the quotation
she sees is M1.5581, which tells her that she can buy 1.5581 marks for a dollar.
She now holds 50 marks, so she wants to know how many U.S. dollars she will
receive for her marks. First, she must find the reciprocal of the quoted indirect
rate,
1
5 $0.6418,
M1.5581
which is the direct quote shown in Table 18-1, Column 1. Then she will end up
with
$0.6418 3 50 5 $32.09.
Slides 18-11, 18-12
In this example, we made three very strong and generally incorrect assumptions. First, we assumed that our traveler had to calculate all the cross rates. For
retail transactions, it is customary to display the cross rates directly instead of a
series of dollar rates. Second, we assumed that exchange rates remain constant
over time. Actually, exchange rates vary every day, often dramatically. We will
have more to say about exchange rate fluctuations in the next section. Finally,
we assumed that there were no transactions costs involved in exchanging currencies. In reality, small retail exchange transactions such as those in our example usually involve fixed and/or sliding scale fees that can easily consume five
or more percent of the transaction amount. However, credit card purchases minimize these fees.
Major business publications such as The Wall Street Journal regularly report
cross rates among key currencies. The reported cross rates for December 19, 1996,
are listed in Table 18-2. When examining the table, note the following points:
1. Column 1 gives indirect quotes for dollars, that is, units of a foreign currency
that can be bought with one U.S. dollar. Examples: $1 will buy 5.2575 French
francs or 1.5581 German marks. Note the consistency with Table 18-1, Column 2.
2. Other columns show number of units of other currencies that can be bought
with one pound, one Swiss franc, etc. Examples: 1 D-mark will buy 0.87741
Canadian dollar, 3.3743 French francs, or 0.64181 U.S. dollar.
3. The rows show direct quotes, that is, number of units of the currency of the
country listed in the left column required to buy one unit of the currency
%%FF148026_709
THE INTERNATIONAL MONETARY SYSTEM
T A B L E
1 8 - 2
709
Key Curre ncy Cross Rat es
Late N ew York Trading Dec e mber 19, 1996
DOLLAR
POUND
SFRANC
GUILDER
PESO
YEN
LIRA
D-MARK
FFRANC
Canada
1.3671
2.2762
1.0206
0.78411
0.17398
0.01199
0.00089
0.87741
0.26003
—
France
5.2575
8.7537
3.9250
3.0155
0.66906
0.04610
0.00343
3.3743
—
3.8457
CDNDLR
Germany
1.5581
2.5942
1.1632
0.89366
0.19828
0.01366
0.00102
—
0.29636
1.1397
Italy
1533.0
2552.4
1144.5
879.27
195.09
13.443
—
983.89
291.58
1121.4
Japan
114.04
189.88
85.136
65.409
14.513
—
0.07439
73.192
21.691
83.417
Mexico
7.8580
13.084
5.8664
4.5070
—
0.06891
0.00513
5.0433
1.4946
5.7479
Netherlands
1.7435
2.9029
1.3016
—
0.22188
0.01529
0.00114
1.1190
0.33162
1.2753
Switzerland
1.3395
2.2303
—
0.76828
0.17046
0.01175
0.00087
0.85970
0.25478
0.97981
United Kingdom
0.60060
—
0.44838
0.34448
0.07643
0.00527
0.00039
0.38547
0.11424
0.43932
United States
—
1.6650
0.74655
0.57356
0.12726
0.00877
0.00065
0.64181
0.19020
0.73148
SOURCE: “Key Currency Cross Rates,” The Wall Street Journal, December 20, 1996, C17. r1996 Dow Jones & Company, Inc. All Rights Reserved
Worldwide.
listed in the top row. The bottom row is particularly interesting, as it shows
the direct quotes for the U.S. dollar. This row is consistent with Column 1 of
Table 18-1. Note too that the values on the bottom row are reciprocals of the
values in Column 1. Thus, 1/0.6006 5 1.6650.
4. Now notice, by reading down the FFranc column, that one French franc was
worth 0.29636 ' 0.2964 German marks. This is the same cross rate that we
calculated for the U.S. tourist in our previous example.
The tie-in with the dollar ensures that all currencies are related to one another
in a consistent manner. If this consistency did not exist, currency traders could
gain profits by buying undervalued currencies and selling overvalued currencies.
This process, known as arbitrage, works to bring about an equilibrium wherein
the same relationship described earlier would exist. In fact, currency traders are
constantly operating in the market, seeking small inconsistencies from which
they can profit. Their existence enables the rest of us to assume that currency
markets are in equilibrium and that, at any point in time, cross rates are all internally consistent.
SELF-TEST QUESTIONS
What is an exchange rate?
Explain the difference between direct and indirect quotations.
What is a cross rate?
THE INTERNATIONAL MONETARY SYSTEM
Slide 18-13
Every nation has a monetary system with a monetary authority. In the United
States, the Federal Reserve is our monetary authority, and its task is to hold down
inflation while promoting economic growth and raising our national standard of
%%FF148026_710
710
CHAPTER 18
MULTINATIONAL FINANCIAL MANAGEMENT
Fixed Exchange Rate System
The world monetary system in
existence after World War II until
1971, under which the value of
the U.S. dollar was tied to gold,
and the values of the other
currencies were pegged to the U.S.
dollar.
Trade Deficit
A situation where a country
imports more than it exports.
EXTRA EXAMPLE
For the last 20 years the United
States has had a large trade deficit with Japan. This results in
large dollar holdings by the Japanese. One use of these dollars has
been for the Japanese to invest in
the United States.
living. Moreover, if countries are to trade with one another, we must have some
sort of system designed to facilitate payments between nations.
From the end of World War II until August 1971, the world was on a fixed
exchange rate system administered by the International Monetary Fund (IMF).
Under this system, the U.S. dollar was linked to gold ($35 per ounce), and other
currencies were then tied to the dollar. Exchange rates between other currencies
and the dollar were controlled within narrow limits but then adjusted periodically. For example, in 1964 the British pound was adjusted to $2.80 for £1, with
a 1 percent permissible fluctuation about this rate.
Fluctuations in exchange rates occur because of changes in the supply of and
demand for dollars, pounds, and other currencies. These supply and demand
changes have two primary sources. First, changes in the demand for currencies
depend on changes in imports and exports of goods and services. For example,
U.S. importers must buy British pounds to pay for British goods, whereas British
importers must buy U.S. dollars to pay for U.S. goods. If U.S. imports from Great
Britain exceeded U.S. exports to Great Britain, there would be a greater demand
for pounds than for dollars, and this would drive up the price of the pound relative to that of the dollar. In terms of Table 18-1, the dollar cost of a pound might
rise from $1.6650 to $2.0000. The U.S. dollar would be said to be depreciating,
because a dollar would now be worth fewer pounds, whereas the pound would be
appreciating. In this example, the root cause of the change would be the U.S.
trade deficit with Great Britain. Of course, if U.S. exports to Great Britain were
greater than U.S. imports from Great Britain, Great Britain would have a trade
deficit with the United States.2
Changes in the demand for a currency, hence exchange rate fluctuations, also
depend on capital movements. For example, suppose interest rates in Great Britain were higher than those in the United States. To take advantage of the high
British interest rates, U.S. banks, corporations, and even sophisticated individuals would buy pounds with dollars and then use those pounds to purchase highyielding British securities. These purchases would tend to drive up the price of
pounds.3
Before August 1971, exchange rate fluctuations were kept within the narrow
1 percent limit by regular intervention of the British government in the market.
2
If the dollar value of the pound moved up from $1.67 to $2.00, this increase in the value of the
pound would mean that British goods would now be more expensive in the United States. For example, a box of candy costing £1 in England would rise in price in the United States from about
$1.67 to $2.00. Conversely, U.S. goods would become cheaper in England. For example, the British
could now buy goods worth $2.00 for £1, whereas before the exchange rate change £1 would buy
merchandise worth only $1.67. These price changes would, of course, tend to reduce British exports
and increase imports, and this, in turn, would lower the exchange rate, because people in the United
States would be buying fewer pounds to pay for English goods. Before 1971, the 1 percent limit severely constrained the market’s ability to reach an equilibrium between trade balances and exchange
rates.
3
Such capital inflows would also tend to drive down British interest rates. If British rates were high
in the first place because of efforts by the British monetary authorities to curb inflation, these international currency flows would tend to thwart that effort. This is one of the reasons domestic and
international economies are so closely linked.
A good example of this occurred during the summer of 1981. In an effort to curb inflation, the
Federal Reserve Board helped push U.S. interest rates to record levels. This, in turn, caused a flow of
capital from European nations to the United States. The Europeans were suffering from a severe
recession and wanted to keep interest rates down in order to stimulate investment, but U.S. policy
made this difficult because of international capital flows. Just the opposite occurred in 1992, when
the Fed drove short-term rates down to record lows in the United States to promote growth, while
Germany and most other European countries pushed their rates higher to combat the inflationary
pressures of reunification. Thus, investment in the United States was dampened as investors moved
their money overseas to capture higher interest rates.
%%FF148026_711
THE INTERNATIONAL MONETARY SYSTEM
Devaluation
The process of officially reducing
the value of a country’s currency
relative to other currencies.
Revaluation
The process of officially increasing
the value of a country’s currency
relative to other currencies.
Floating Exchange Rates
A system under which exchange
rates are not fixed by government
policy but are allowed to float up
or down in accordance with
supply and demand.
Slide 18-14
EXTRA EXAMPLE
Trade barriers also affect the cost
of imported products. For example, Japan imposes many tariffs on foreign goods that cause
these products to be noncompetitive in the Japanese markets.
Many believe these barriers significantly influence the size of the
U.S. trade deficit with Japan.
711
When the value of the pound was falling, the Bank of England would step in and
buy pounds to push up their price, offering gold or foreign currencies in
exchange. Conversely, when the pound rate was too high, the Bank of England
would sell pounds. The central banks of other countries operated similarly.
Devaluations and revaluations occurred only rarely before 1971. They were
usually accompanied by severe international financial repercussions, partly because nations tended to postpone needed measures until economic pressures had
built up to explosive proportions. For this and other reasons, the old international monetary system came to a dramatic end in the early 1970s, when the
U.S. dollar, the foundation upon which all other currencies were anchored, was
cut loose from the gold standard and, in effect, allowed to “float.”
The United States and other major trading nations currently operate under a
system of floating exchange rates, whereby currency prices are allowed to seek
their own levels without much governmental intervention. However, the central
bank of each country does intervene to some extent, buying and selling its currency to smooth out exchange rate fluctuations.
Each central bank would like to keep its average exchange rate at a level deemed
desirable by its government’s economic policy. This is important, because
exchange rates have a profound effect on the levels of imports and exports, which
influence the level of domestic employment. For example, if a country is having
a problem with unemployment, its central bank might try to lower interest rates,
which would cause capital to flee the country to find higher rates, which would lead
to the sale of the currency, which would cause a decline in the value of the currency.
This would cause its goods to be cheaper in world markets and thus stimulate exports, production, and domestic employment. Conversely, the central bank of a
country that is operating at full capacity and experiencing inflation might try to
raise the value of its currency to reduce exports and increase imports. Under the
current floating rate system, however, such intervention can affect the situation
only temporarily, because market forces will prevail in the long run.
Exchange rate fluctuations can have a profound impact on international monetary transactions. For example, in 1985 it cost Honda Motors 2,380,000 yen to
build a particular model in Japan and ship it to the United States. The model
carried a U.S. sticker price of $12,000. Since the $12,000 sales price was the
equivalent of (238 yen per dollar)($12,000) 5 2,856,000 yen, which was 20 percent above the 2,380,000 yen cost, the automaker had built a 20 percent markup
into the U.S. sales price. However, three years later the dollar had depreciated to
128 yen. Now if the model still sold for $12,000, the yen return to Honda would
be only (128 yen per dollar)($12,000) 5 1,536,000 yen, and the automaker would
be losing about 35 percent on each auto sold. Therefore, the depreciation of the
dollar against the yen turned a healthy profit into a huge loss. In fact, for Honda
to maintain its 20 percent markup, the model would have to sell in the United
States for 2,856,000 yen/128 yen per dollar 5 $22,312.50. This situation, which
had grown even worse by 1996, with 114 yen per dollar, led Honda to build its
most popular model, the Accord, in Marysville, Ohio.
The inherent volatility of exchange rates under a floating system increases the
uncertainty of the cash flows for a multinational corporation. Because these cash
flows are generated in many parts of the world, they are denominated in many
different currencies. Since exchange rates can change, the dollar-equivalent value
of a company’s consolidated cash flows can also fluctuate. For example, Toyota
estimates that each one-yen drop in the dollar reduces the company’s annual net
income by about 10 billion yen. This is known as exchange rate risk, and it is a
major factor differentiating a global company from a purely domestic one.
%%FF148026_712
712
CHAPTER 18
MULTINATIONAL FINANCIAL MANAGEMENT
Pegged Exchange Rate
Occurs when a country establishes
a fixed exchange rate with another
major currency; consequently,
values of pegged currencies move
together over time.
Convertible Currency
A currency that may be readily
exchanged for other currencies.
Slides 18-15, 18-16
Concerns about exchange rate risk have spurred attempts to stabilize currency
movements. In 1979, The European Monetary System (EMS) was formed. Participants in the EMS agreed to limit fluctuations in their exchange rates so that
rates stayed within a prespecified range. It was felt that this arrangement would
prevent the frequent disruptions to international trade and economic health that
were caused by the vagaries of a floating foreign exchange market. However, efforts to fix exchange rates rather than letting them float have not met with much
success. For example, in the 1990s, Britain was forced to withdraw from the exchange rate arrangement of the EMS because of its inability to support the pound.
Similarly, in 1995, while facing substantial political and economic turmoil,
Mexico attempted to stabilize the peso. However, participants in the foreign exchange market simply sold billions of pesos and forced the Mexican central bank
to allow the peso to float.
European nations are now moving toward an alternative to the EMS. Under
the Treaty of Maastricht (signed in 1991), participants in the European Monetary Union (EMU) agreed to take a step beyond merely trying to fix their exchange rates relative to each other. They agreed to move to a common currency,
the Euro, that will replace the currencies of the member countries. The hope is
that such an arrangement will be more successful than the arrangements of the
past in terms of creating a stable international economic environment.
Note too that in today’s floating exchange rate environment, many countries
have chosen to peg their currencies to one or more major currencies. Countries
with pegged exchange rates establish a fixed exchange rate with some major currency, and then the values of the pegged currencies move together over time.
For example, Venezuela pegs its currency to the U.S. dollar at a rate of 0.002107
Bolivar per dollar. Its reason for pegging its currency to the dollar is that a large
portion of its revenues are linked to its oil exports, which are typically traded in
dollars, and its trading partners feel more comfortable dealing with contracts that
can, in essence, be stated in dollar terms. Similarly, Kuwait pegs its currency to
a composite of currencies that roughly represents the mix of currencies used by
its trading partners to purchase its oil. In other instances, currencies are pegged
because of traditional ties — for example, Chad, a former French colony, still pegs
its currency to the French franc.4
Before closing our discussion of the international monetary system, we should
note that not all currencies are convertible. A currency is convertible when the
nation which issued the currency allows it to be traded in the currency markets
and is willing to redeem it at market rates. This means that, except for limited
central bank influence, the issuing government loses control over the value of
its currency. Lack of convertibility creates major problems for international trade.
For example, consider the situation faced by Pepsico when it wanted to open a
chain of Pizza Hut restaurants in the Soviet Union. The Russian ruble is not convertible, so Pepsico could not take the profits from its restaurants out of the Soviet Union in the form of dollars. There was no mechanism to exchange the rubles
it earned in Russia for dollars, so the investment in the Soviet Union was essentially worthless to the U.S. parent. However, Pepsico arranged to use the ruble
profit from the restaurants to buy Russian vodka, which it then shipped to the
United States and sold for dollars. Pepsico managed to work things out, but lack
of convertibility significantly inhibits the ability of a country to attract foreign
investment.
4
The International Monetary Fund reports each year a full listing of exchange rate arrangements in
its International Monetary Statistics.
%%FF148026_713
TRADING IN FOREIGN EXCHANGE
713
SELF-TEST QUESTIONS
What is the difference between a fixed exchange rate system and a floating
rate system? Which system is better? Explain.
What are pegged exchange rates?
What does it mean to say that the dollar is depreciating with respect to the
British pound? For a U.S. consumer of British goods, would this be good or
bad? How could changes in consumption arrest the decline of the dollar?
What is a convertible currency?
TRADING IN FOREIGN EXCHANGE
ON THE WWW
Current currency future prices are
available directly from the Chicago Mercantile Exchange (CME)
on their Web site at http://
www.cme.com/market/
hotquote.html. The quotes are
updated every ten minutes
throughout the trading session.
Updated currency spot and forward rates (from 1 to 12 months)
are also provided by the Bank of
Montreal Treasury Group at http:/
/www.bmo.com/economic/
fxrates.htm.
Spot Rate
The effective exchange rate for a
foreign currency for delivery on
(approximately) the current day.
Forward Exchange Rate
An agreed-upon price at which
two currencies will be exchanged
at some future date.
Slides 18-17, 18-18
TM 18-5
Discount on Forward Rate
The situation when the spot rate
is less than the forward rate.
Importers, exporters, tourists, and governments buy and sell currencies in the
foreign exchange market. For example, when a U.S. trader imports automobiles
from Germany, payment will probably be made in German marks. The importer
buys marks (through its bank) in the foreign exchange market, much as one buys
common stocks on the New York Stock Exchange or pork bellies on the Chicago
Mercantile Exchange. However, whereas stock and commodity exchanges have
organized trading floors, the foreign exchange market consists of a network of
brokers and banks based in New York, London, Tokyo, and other financial centers. Most buy and sell orders are conducted by computer and telephone.5
SPOT RATES AND FORWARD RATES
The exchange rates shown earlier in Tables 18-1 and 18-2 are known as spot rates,
which means the rate paid for delivery of the currency “on the spot” or, in reality, no more than two days after the day of the trade. For most of the world’s
major currencies, it is also possible to buy (or sell) currencies for delivery at some
agreed-upon future date, usually 30, 90, or 180 days from the day the transaction is negotiated. This rate is known as the forward exchange rate. For example,
if a U.S. firm must make payment to a Japanese firm in 30 days, the U.S. firm’s
treasurer can buy Japanese yen today for delivery in 30 days, paying the 30-day
forward rate of $0.0088 per Japanese yen (which equals 113.50 yen per dollar).
Forward rates are analogous to futures prices on commodity exchanges, where
contracts are drawn up for wheat or corn to be delivered at agreed-upon prices
at some future date. The contract is signed today, and the future dollar cost of
the Japanese yen is then known with certainty. Purchasing a forward contract is
one technique for eliminating the volatility of future cash flows caused by fluctuations in exchange rates. This technique, which is called “hedging,” will be discussed in more detail in Chapter 19.
Recent forward rates for 30-, 90-, and 180-day delivery, along with the current
spot rates for some commonly traded currencies, are given in Table 18-3. If one
can obtain more of the foreign currency for a dollar in the forward than in the
spot market, the forward currency is less valuable than the spot currency, and
the forward currency is said to be selling at a discount. Thus, because 1 dollar
could buy 0.6006 British pound in the spot market but 0.6035 pound in the 1805
For a more detailed explanation of exchange rate determination and operations of the foreign exchange market, see Mark Eaker, Frank Fabozzi, and Dwight Grant, International Corporate Finance
(Fort Worth, TX: Dryden Press, 1996).
%%FF148026_714
714
CHAPTER 18
MULTINATIONAL FINANCIAL MANAGEMENT
T A B L E
1 8 - 3
Selected S pot a nd Forwa rd Ex c hange Rat es, Dec e mber 19, 1996
(N umber o f Unit s of Fore ign Curre ncy per U.S. Dolla r)
FORWARD RATES
SPOT
RATE
180
DAYS
90
DAYS
30
DAYS
FORWARD RATE AT A
PREMIUM OR DISCOUNT
British pound
0.6006
0.6009
0.6019
0.6035
Discount
Japanese yen
114.0400
113.5000
112.5900
111.1300
Premium
German mark
1.5581
1.5551
1.5493
1.5401
Premium
NOTES:
a. These are representative quotes as provided by a sample of New York banks. Forward rates for
other currencies and for other lengths of time can often be negotiated.
b. When it takes more units of a foreign currency to buy one dollar in the future, the value of the
foreign currency is less in the forward market than in the spot market, hence the forward rate is at
a discount to the spot rate.
SOURCE: The Wall Street Journal, December 20, 1996.
Premium on Forward Rate
The situation when the spot rate
is greater than the forward rate.
day forward market, forward pounds sell at a discount as compared with spot
pounds. Conversely, since a dollar would buy fewer yen in the forward than in
the spot market, the forward yen is selling at a premium.
SELF-TEST QUESTIONS
Differentiate between spot and forward exchange rates.
Explain what it means for a forward currency to sell at a discount, and at a
premium.
INTEREST RATE PARITY
Interest Rate Parity
Specifies that investors should
expect to earn the same return in
all countries after adjusting for
risk.
Slide 18-19
TMs 18-6 through 18-9
Market forces determine whether a currency sells at a forward premium or discount, and the relationship between spot and forward exchange rates is summarized in a concept called interest rate parity.
Interest rate parity holds that investors should expect to earn the same return in all countries after adjusting for risk. It recognizes that when you invest
in a country other than your home country, you are affected by two forces —
returns on the investment itself and changes in the exchange rate. It follows that
your overall return will be higher than the investment’s stated return if the currency your investment is denominated in appreciates relative to your home currency. Likewise, your overall return will be lower if the overseas currency you
are holding declines in value.
Interest rate parity is expressed as follows:
ft
e0
Slides 18-20, 18-21
5
(1 1 kh)
(1 1 kf)
.
Here ft is the t-period forward exchange rate and e0 is today’s spot exchange rate,
both expressed in terms of the amount of home currency received per unit of
%%FF148026_715
INTEREST RATE PARITY
LECTURE NOTE
Interest rate parity represents an
equilibrium situation between
spot and forward exchange rates
of the currencies. If this condition
is not met, then arbitrageurs
should quickly bring interest rates
back to parity.
715
foreign currency, and kh and kf are the periodic interest rates in the home country and the foreign country, respectively. If this relationship, which is defined as
interest rate parity, does not hold, then currency traders will buy and sell currencies — that is, engage in arbitrage — until it does hold.
To illustrate interest rate parity, consider the case of a U.S. investor who can
buy default-free 90-day German bonds that promise a 4 percent nominal return
and are denominated in German marks. The 90-day rate, kf, is 4%/4 5 1% because 90 days is 1/4 of a 360-day year. Assume also that the spot exchange rate is
e0 5 $0.6418, which means that you can exchange 0.6418 dollar for one mark,
or 1.5581 marks per dollar. Finally, assume that the 90-day forward exchange
rate, ft, is $0.6455, which means that you can exchange one mark for 0.6455
dollar, or receive 1.5493 marks per dollar exchanged, 90 days from now.
The U.S. investor can receive a 4 percent annualized return denominated in
marks, but if he or she ultimately wants to consume goods in the United States,
those marks must be converted to dollars. The dollar return of the investment
depends, therefore, on what happens to exchange rates over the next three
months. However, the investor can lock in the dollar return by selling the foreign currency in the forward market. For example, the investor could simultaneously
♦ Convert $1,000 to 1,558.1 marks in the spot market.
Slide 18-22
♦ Invest the 1,558.1 marks in 90-day German bonds that have a 4 percent
annualized return or a 1 percent quarterly return, hence will pay (1,558.1)
(1.01) 5 1,573.68 marks in 90 days.
♦ Agree today to exchange these 1,573.68 marks 90 days from now at the 90day forward exchange rate of 1.5493 marks per dollar, or for a total of
$1,015.74.
EXTRA EXAMPLE
The state of Kentucky sold yendenominated “samurai bonds” to
investors in the Japanese bond
markets. After hedging for currency risk, Kentucky was able to
save roughly 50 basis points in
yield over what they would have
been charged in the U.S. markets.
Kentucky officials feel that demonstrating their willingness to
compete in the Japanese financial
markets also serves as a way to
attract Japanese corporations to
their state.
This investment, therefore, has an expected 90-day return of $15.74/$1,000 5
1.57%, which translates into a nominal return of 4(1.57%) 5 6.28%. In this case,
4 percent of the expected 6.28 percent return is coming from the bond itself,
and 2.28 percent arises because the market believes the mark will strengthen
relative to the dollar. Notice that by locking in the forward rate today, the investor has eliminated any exchange rate risk. And, since the German bond is assumed to be default-free, the investor is assured of earning a 6.28 percent dollar
return.
Interest rate parity implies that an investment in the United States with the
same risk as a German bond should have a return of 6.28 percent. Solving for kh
in the preceding equation, we indeed find that the predicted interest rate in the
United States is 6.28 percent.
Interest rate parity shows why a particular currency might be at a forward
premium or discount. Notice that a currency is at a forward premium (ft . e0)
whenever domestic interest rates are higher than foreign interest rates (kh . kf).
Discounts prevail if domestic interest rates are lower than foreign interest rates.
If these conditions do not hold, then arbitrage will soon force interest rates back
to parity.
SELF-TEST QUESTION
Briefly explain interest rate parity, illustrating with an example.
%%FF148026_716
716
CHAPTER 18
MULTINATIONAL FINANCIAL MANAGEMENT
G
G LL O
O B
B A
A LL
HUNGRY FOR A
BIG MAC? GO TO
CHINA!
Purchasing power parity (PPP) implies that the same product will sell
for the same price in every country
after adjusting for current exchange
rates. One problem when testing to
see if PPP holds is that it assumes
that goods consumed in different
countries are of the same quality. For
example, if you find that a product is
more expensive in Italy than it is in
Switzerland, one explanation is that
PPP fails to hold, but another explanation is that the product sold in
Italy is of a higher quality and therefore deserves a higher price.
One way to test for PPP is to find
goods that have the same quality
worldwide. With this in mind, the
Economist magazine occasionally
compares the prices of a well-known
good whose quality is the same in
nearly 80 different countries: the McDonald’s Big Mac hamburger.
P
P E
E R
R S
S P
P E
E C
C TT II VV E
E S
S
The table on the next page provides information collected during
1995. The first column shows the
price of a Big Mac in the local currency. Column 2 calculates the price
of the Big Mac in terms of the U.S.
dollar — this is obtained by dividing
the local price by the actual exchange
rate at that time. For example, a Big
Mac costs 18.5 French francs in
Paris. Given an exchange rate of 4.80
francs per dollar, this implies that the
dollar price of a Big Mac is 18.5
francs/4.80 francs per dollar 5 $3.85.
The third column backs out the
implied exchange rate that would
hold under PPP. This is obtained by
dividing the price of the Big Mac in
each local currency by its U.S. price.
For example, a Big Mac costs 8,100
rubles in Russia, and $2.32 in the
United States. If PPP holds, the exchange rate should be 3,491 rubles
per dollar (8,100 rubles)/($2.32).
Comparing the implied exchange
rate to the actual exchange rate in
Column 4, we see the extent to which
the local currency is under- or overvalued relative to the dollar. Given
that the actual exchange rate at the
time was 4,985 rubles per dollar, this
implies that the ruble was 30 percent
undervalued.
The evidence suggests that strict
PPP does not hold, but the Big Mac
test may shed some insights about
where exchange rates are headed. For
example, the Big Mac 1995 test suggests that the yen was highly overvalued relative to the dollar, and since
that time the dollar has strengthened
roughly 30 percent relative to the
yen.
One last benefit of the Big Mac
test is that it tells us the cheapest
places to find a Big Mac. According
to the data, if you are looking for a
Big Mac, head to China, and avoid
Switzerland.
SOURCE: Excerpted from “Big MacCurrencies,” The Economist, April 15, 1995, 74.
Reprinted by permission from The Economist.
ON THE WWW
The full text of the 1996 purchasing power parity article from The
Economist, entitled “McCurrencies: Where’s the Beef?”, is available at http://economist.
iconnet.net/issue/27-04-96/
fn1.html. The article, short and
entertaining, includes a table
similar to the one presented in
the textbook, except the data is
one year newer, thereby providing
the opportunity to observe currency fluctuation in action.
Purchasing Power Parity
The relationship where the same
products cost roughly the same
amount in different countries after
taking into account the exchange
rate.
Slide 18-23
PURCHASING POWER PARITY
We have discussed exchange rates in some detail, and we have considered the
relationship between spot and forward exchange rates, but we have not yet addressed the fundamental question: What determines the level of exchange rates
in each country? As it turns out, exchange rates are influenced by a multitude of
factors that are difficult to predict, particularly on a day-to-day basis. However,
market forces work to ensure that similar goods sell for similar prices in different countries after taking exchange rates into account. This relationship is known
as purchasing power parity.
Purchasing power parity (PPP), sometimes referred to as the law of one price,
implies that the level of exchange rates adjusts so that identical goods cost the
same amount in different countries. For example, if a pair of tennis shoes costs
$150 in the United States and 100 pounds in Britain, PPP would imply that the
exchange rate would be $1.50 per pound. Consumers could purchase the shoes
in Britain for 100 pounds, or they could exchange their 100 pounds for $150 and
then purchase the same shoes in the United States at the same effective cost,
%%FF148026_717
PURCHASING POWER PARITY
717
BIG MAC PRICES
United Statesc
Argentina
Australia
Britain
Canada
China
Denmark
France
Germany
Hong Kong
Italy
Japan
Mexico
Russia
Spain
Switzerland
Thailand
IN LOCAL
CURRENCY
(1)
$2.32
Peso 3.00
A$2.45
£1.74
C$2.77
Yuan9.00
DKr26.75
FFr18.5
DM4.80
HK$9.50
Lire4,500
¥ 391
Peso10.9
Ruble8,100
Ptas355
SFr5.90
Baht48.0
DOLLARS
(2)
IMPLIED EXCHANGE
RATE BASED ON PPPa
(3)
ACTUAL $
EXCHANGE
RATE 7/4/95
(4)
LOCAL CURRENCY
UNDER(!)/OVER(~)
VALUATIONb(%)
(5)
2.32
3.00
1.82
2.80
1.99
1.05
4.92
3.85
3.48
1.23
2.64
4.65
1.71
1.62
2.86
5.20
1.95
—
1.29
1.06
1.33d
1.19
3.88
11.50
7.97
2.07
4.09
1,940.00
169.00
4.70
3,491.00
153.00
2.54
20.70
—
1.00
1.35
1.61d
1.39
8.54
5.43
4.80
1.38
7.73
1,702.00
84.20
6.37
4,985.00
124.00
1.13
24.60
—
129
222
121
214
255
1112
166
150
247
114
1100
226
230
123
1124
216
IN
NOTES:
a
Purchasing power parity: local price divided by price in the United States.
Against dollar.
c
Average of New York, Chicago, San Francisco, and Atlanta.
d
Dollars per pound.
SOURCE: McDonald’s.
b
Slide 18-24
assuming no transaction or transportation costs. Here is the equation for purchasing power parity:
Ph 5 (Pf)(e0),
TM 18-10
or
e0 5
LECTURE NOTE
Purchasing power parity holds
only in the absence of tariffs,
trade restrictions, transaction
costs, and shipping costs. Although
analyzing PPP in the real world is
complex, understanding the relationships between the prices of
goods and currency exchange
rates is critical for financial
managers of multinational
corporations.
Ph
Pf
.
Here
Ph 5 the price of the good in the home country ($150, assuming the United
States is the home country).
Pf 5 the price of the good in the foreign country (100 pounds).
e0 5 the spot market exchange rate, expressed as the number of units of home
currency that can be exchanged for one unit of foreign currency ($1.50
per pound).
PPP assumes that market forces will eliminate situations where the same product sells at a different price overseas. For example, if the shoes cost $140 in the
%%FF148026_718
718
CHAPTER 18
MULTINATIONAL FINANCIAL MANAGEMENT
United States, importers/exporters could purchase the shoes in the United States
for $140, sell the shoes for 100 pounds in Britain, exchange the 100 pounds for
$150 in the foreign exchange market, and earn a profit of $10 on every pair of
shoes. This situation violates PPP, because $140 5 Ph , (Pf)(e0) 5 $150. Ultimately, this trading activity would increase the demand for shoes in the United
States and thus Ph, increase the supply of shoes in Britain and thus reduce Pf,
and increase the demand for dollars in the foreign exchange market and thus
reduce e0. Each of these actions works to restore PPP.
Notice that PPP assumes there are no transportation or transaction costs, or
regulations, which limit the ability to ship goods between countries. In many
cases, these assumptions are incorrect, which explains why PPP is often violated.
An additional complication, when empirically testing to see whether PPP holds,
is that products in different countries are rarely identical. Frequently, there are
real or perceived differences in quality, which can lead to price differences in different countries.
The concepts of interest rate and purchasing power parity are critically important to those engaged in international activities. Companies and investors
must anticipate changes in interest rates, inflation, and exchange rates, and they
often try to hedge the risks of adverse movements in these factors. The parity
relationships are extremely useful in judging and anticipating future conditions.
SELF-TEST QUESTION
What is meant by purchasing power parity? Illustrate it.
INFLATION, INTEREST RATES,
AND EXCHANGE RATES
Slide 18-25
LECTURE NOTE
The longer the measurement period, the greater the effect of different inflation rates on the exchange rate. The concept can be
explained by comparing the price
of goods in two countries to two
elevators with bouncing balls inside each. The height above the
ground of the bouncing balls represent the relative prices of goods.
If the elevators rise at different
speeds (different inflation rates),
the more time that passes, the
less important the relative price
effects (ball bounces) are compared with the inflation effects.
Relative inflation rates, or the rates of inflation in foreign countries compared
with that in the home country, have many implications for multinational financial decisions. Obviously, relative inflation rates will greatly influence future production costs at home and abroad. Equally important, inflation has a dominant
influence on relative interest rates and exchange rates. Both of these factors influence the methods chosen by multinational corporations for financing their foreign investments, and both have an important effect on the profitability of
foreign investments.
The currencies of countries with higher inflation rates than that of the United
States by definition depreciate over time against the dollar. Countries where this
has occurred include France, Italy, Mexico, and all the South American nations.
On the other hand, the currencies of Germany, Switzerland, and Japan, which
have had less inflation than the United States, have appreciated against the dollar. In fact, a foreign currency will, on average, depreciate or appreciate at a
percentage rate approximately equal to the amount by which its inflation rate
exceeds or is less than our own.
Relative inflation rates also affect interest rates. The interest rate in any country is largely determined by its inflation rate. Therefore, countries currently experiencing higher rates of inflation than the United States also tend to have higher
interest rates. The reverse is true for countries with lower inflation rates.
It is tempting for a multinational corporation to borrow in countries with the
lowest interest rates. However, this is not always a good strategy. Suppose, for
%%FF148026_719
INTERNATIONAL MONEY AND CAPITAL MARKETS
719
example, that interest rates in Germany are lower than those in the United States
because of Germany’s lower inflation rate. A U.S. multinational firm could therefore save interest by borrowing in Germany. However, because of relative inflation rates, the mark will probably appreciate in the future, causing the dollar
cost of annual interest and principal payments on German debt to rise over time.
Thus, the lower interest rate could be more than offset by losses from currency
appreciation. Similarly, multinational corporations should not necessarily avoid
borrowing in a country such as Brazil, where interest rates have been very high,
because future depreciation of the Brazilian cruzeiro could make such borrowing end up being relatively inexpensive.
SELF-TEST QUESTIONS
What effects do relative inflation rates have on relative interest rates?
What happens over time to the currencies of countries with higher inflation
rates than that of the United States? To those with lower inflation rates?
Why might a multinational corporation decide to borrow in a country such as
Brazil, where interest rates are high, rather than in a country like Germany,
where interest rates are low?
INTERNATIONAL MONEY
AND CAPITAL MARKETS
Slide 18-26
One way for U.S. citizens to invest in world markets is to buy the stocks of U.S.
multinational corporations that invest directly in foreign countries. Another way
is to purchase foreign securities — stocks, bonds, or money market instruments
issued by foreign companies. Security investments are known as portfolio investments, and they are distinguished from direct investments in physical assets by
U.S. corporations.
From World War II through the 1960s, the U.S. capital markets dominated
world markets. Today, however, the value of U.S. securities represents less than
one-fourth the value of all securities. Given this situation, it is important for both
corporate managers and investors to have an understanding of international markets. Moreover, these markets often offer better opportunities for raising or investing capital than are available domestically.
EURODOLLAR MARKET
Eurodollar
A U.S. dollar deposited in a bank
outside the United States.
A Eurodollar is a U.S. dollar deposited in a bank outside the United States. (Although they are called Eurodollars because they originated in Europe, Eurodollars are really any dollars deposited in any part of the world other than the United
States.) The bank in which the deposit is made may be a non-U.S. bank, such as
Barclay’s Bank in London; the foreign branch of a U.S. bank, such as Citibank’s
Paris branch; or even a foreign branch of a third-country bank, such as Barclay’s
Munich branch. Most Eurodollar deposits are for $500,000 or more, and they
have maturities ranging from overnight to about one year.
The major difference between Eurodollar deposits and regular U.S. time deposits is their geographic locations. The two types of deposits do not involve different currencies — in both cases, dollars are on deposit. However, Eurodollars
%%FF148026_720
720
CHAPTER 18
MULTINATIONAL FINANCIAL MANAGEMENT
ON THE WWW
Current three-month and sixmonth LIBOR rates can be obtained from a site maintained by
Kuhlmann Commercial Capital at
http://www.kuhlmann.com/
rates.html. The site also allows
the user to view historical charts
of the LIBOR rates.
are outside the direct control of the U.S. monetary authorities, so U.S. banking
regulations, including reserve requirements and FDIC insurance premiums, do
not apply. The absence of these costs means that the interest rate paid on Eurodollar deposits can be higher than domestic U.S. rates on equivalent instruments.
Although the dollar is the leading international currency, British pounds, German marks, Swiss francs, Japanese yen, and other currencies are also deposited
outside their home countries; these Eurocurrencies are handled in exactly the
same way as Eurodollars.
Eurodollars are borrowed by U.S. and foreign corporations for various purposes, but especially to pay for goods exported from the United States and to
invest in U.S. security markets. Also, U.S. dollars are used as an international
currency, or international medium of exchange, and many Eurodollars are used
for this purpose. It is interesting to note that Eurodollars were actually “invented”
by the Soviets in 1946. International merchants did not trust the Soviets or their
rubles, so the Soviets bought some dollars (for gold), deposited them in a Paris
bank, and then used these dollars to buy goods in the world markets. Others
found it convenient to use dollars this same way, and soon the Eurodollar market was in full swing.
Eurodollars are usually held in interest-bearing accounts. The interest rate
paid on these deposits depends (1) on the bank’s lending rate, as the interest a
bank earns on loans determines its willingness and ability to pay interest on deposits, and (2) on rates of return available on U.S. money market instruments. If
money market rates in the United States were above Eurodollar deposit rates,
these dollars would be sent back and invested in the United States, whereas if
Eurodollar deposit rates were significantly above U.S. rates, which is more often
the case, more dollars would be sent out of the United States to become Eurodollars. Given the existence of the Eurodollar market and the electronic flow of
dollars to and from the United States, it is easy to see why interest rates in the
United States cannot be insulated from those in other parts of the world.
Interest rates on Eurodollar deposits (and loans) are tied to a standard rate
known by the acronym LIBOR, which stands for London InterBank Offer Rate.
LIBOR is the rate of interest offered by the largest and strongest London banks
on dollar deposits of significant size. In December 1996, LIBOR rates were over
half a percentage point above domestic U.S. bank rates on time deposits of the
same maturity — 4.94 percent for three-month CDs versus 5.63 percent for
LIBOR CDs. The Eurodollar market is essentially a short-term market; most
loans and deposits are for less than one year.
INTERNATIONAL BOND MARKETS
Foreign Bond
A bond sold by a foreign borrower
but denominated in the currency
of the country in which it is sold.
Any bond sold outside the country of the borrower is called an international bond.
However, there are two important types of international bonds: foreign bonds and
Eurobonds. Foreign bonds are bonds sold by a foreign borrower but denominated in the currency of the country in which the issue is sold. For instance,
Northern Telcom (a Canadian company) may need U.S. dollars to finance the operations of its subsidiaries in the United States. If it decides to raise the needed
capital in the U.S. bond market, the bond will be underwritten by a syndicate of
U.S. investment bankers, denominated in U.S. dollars, and sold to U.S. investors
in accordance with SEC and applicable state regulations. Except for the foreign
origin of the borrower, this bond will be indistinguishable from those issued by
equivalent U.S. corporations. Since Northern Telcom is a foreign corporation,
however, the bond will be called a foreign bond.
%%FF148026_721
INTERNATIONAL MONEY AND CAPITAL MARKETS
Eurobond
A bond sold in a country other
than the one in whose currency
the bond is denominated.
IDEA TO EMPHASIZE
In this section, a number of different instruments have been discussed. The students should recognize that most of the more
useful domestic securities with
which they are familiar are available in a similar form in the international markets.
721
The term Eurobond is used to designate any bond issued in one country but
denominated in the currency of some other country. Examples include a Ford
Motor Company issue denominated in dollars and sold in Germany, or a British
firm’s sale of mark-denominated bonds in Switzerland. The institutional arrangements by which Eurobonds are marketed are different than those for most other
bond issues, with the most important distinction being a far lower level of required disclosure than is usually found for bonds issued in domestic markets,
particularly in the United States. Governments tend to be less strict when regulating securities denominated in foreign currencies, because the bonds’ purchasers are generally more “sophisticated.” The lower disclosure requirements result
in lower total transaction costs for Eurobonds.
Eurobonds appeal to investors for several reasons. Generally, they are issued
in bearer form rather than as registered bonds, so the names and nationalities of
investors are not recorded. Individuals who desire anonymity, whether for privacy reasons or for tax avoidance, like Eurobonds. Similarly, most governments
do not withhold taxes on interest payments associated with Eurobonds. If the
investor requires an effective yield of 10 percent, a Eurobond that is exempt from
tax withholding would need a coupon rate of 10 percent. Another type of bond —
for instance, a domestic issue subject to a 30 percent withholding tax on interest
paid to foreigners — would need a coupon rate of 14.3 percent to yield an afterwithholding rate of 10 percent. Investors who desire secrecy would not want to
file for a refund of the tax, so they would prefer to hold the Eurobond.
More than half of all Eurobonds are denominated in dollars. Bonds in Japanese yen, German marks, and Dutch guilders account for most of the rest. Although centered in Europe, Eurobonds are truly international. Their underwriting syndicates include investment bankers from all parts of the world, and the
bonds are sold to investors not only in Europe but also in such faraway places as
Bahrain and Singapore. Up to a few years ago, Eurobonds were issued solely by
multinational firms, by international financial institutions, or by national governments. Today, however, the Eurobond market is also being tapped by purely
domestic U.S. firms, because they often find that by borrowing overseas they can
lower their debt costs.
INTERNATIONAL STOCK MARKETS
New issues of stock are sold in international markets for a variety of reasons. For
example, a non-U.S. firm might sell an equity issue in the United States because
it can tap a much larger source of capital than in its home country. Also, a U.S.
firm might tap a foreign market because it wants to create an equity market presence to accompany its operations in that country. Large multinational companies also occasionally issue new stock simultaneously in multiple countries. For
example, Alcan Aluminum, a Canadian company, recently issued new stock in
Canada, Europe, and the United States simultaneously, using different underwriting syndicates in each market.
In addition to new issues, outstanding stocks of large multinational companies are increasingly being listed on multiple international exchanges. For example, Coca-Cola’s stock is traded on six stock exchanges in the United States,
four stock exchanges in Switzerland, and the Frankfurt stock exchange in Germany. Some foreign stocks are listed in the United States — an example here is
Royal Dutch Petroleum, which is listed on the NYSE. U.S. investors can also invest in foreign companies through American Depository Receipts (ADRs), which
are certificates representing ownership of foreign stock held in trust. About 1,300
%%FF148026_722
722
CHAPTER 18
MULTINATIONAL FINANCIAL MANAGEMENT
ADRs are now available in the United States, with most of them traded on the
over-the-counter (OTC) market. However, more and more ADRs are being listed
on the New York Stock Exchange, including Germany’s Daimler-Benz, England’s
British Airways, Japan’s Honda Motors, and Italy’s Fiat Group.
SELF-TEST QUESTIONS
Differentiate between foreign portfolio investments and direct foreign investments.
What are Eurodollars?
Has the development of the Eurodollar market made it easier or more difficult for the Federal Reserve to control U.S. interest rates?
Differentiate between foreign bonds and Eurobonds.
Why do Eurobonds appeal to investors?
MULTINATIONAL CAPITAL BUDGETING
Repatriation of Earnings
The process of sending cash flows
from a foreign subsidiary back to
the parent company.
Up to now, we have discussed the general environment in which multinational
firms operate. In the remainder of the chapter, we will see how international factors affect key corporate decisions. We begin with capital budgeting. Although
the same basic principles of capital budgeting analysis apply to both foreign and
domestic operations, there are some key differences. First, cash flow estimation
is more complex for overseas investments. Most multinational firms set up separate subsidiaries in each foreign country in which they operate, and the relevant
cash flows for the parent company are the dividends and royalties paid by the
subsidiaries to the parent. Second, these cash flows must be converted into the
parent company’s currency, hence they are subject to exchange rate risk. For example, General Motors’ German subsidiary may make a profit of 100 million
marks in 1998, but the value of this profit to GM will depend on the dollar/mark
exchange rate: How many dollars will 100 million marks buy?
Dividends and royalties are normally taxed by both foreign and home-country
governments. Furthermore, a foreign government may restrict the amount of
the cash that may be repatriated to the parent company. For example, some governments place a ceiling, stated as a percentage of the company’s net worth, on
the amount of cash dividends that a subsidiary can pay to its parent. Such restrictions are normally intended to force multinational firms to reinvest earnings in the foreign country, although restrictions are sometimes imposed to
prevent large currency outflows, which might disrupt the exchange rate.
Whatever the host country’s motivation for blocking repatriation of profits,
the result is that the parent corporation cannot use cash flows blocked in the
foreign country to pay dividends to its shareholders or to invest elsewhere in the
business. Hence, from the perspective of the parent organization, the cash flows
relevant for foreign investment analysis are the cash flows that the subsidiary is
actually expected to send back to the parent. The present value of those cash
flows is found by applying an appropriate discount rate, and this present value is
then compared with the parent’s required investment to determine the project’s
NPV.
In addition to the complexities of the cash flow analysis, the cost of capital
may be different for a foreign project than for an equivalent domestic project,
%%FF148026_723
MULTINATIONAL CAPITAL BUDGETING
Exchange Rate Risk.
The risk that relates to what the
basic cash flows will be worth in
the parent company’s home
currency.
Political Risk
Potential actions by a host
government which would reduce
the value of a company’s
investment.
IDEA TO EMPHASIZE
Investing in foreign countries involves additional risk. This risk
must be accounted for in the
capital budgeting task, but it
must be recognized that accurately measuring this risk is very
difficult.
T A B L E
1 8 - 4
723
because foreign projects may be more or less risky. A higher risk could arise
from two primary sources — (1) exchange rate risk and (2) political risk. A lower
risk might result from international diversification.
Exchange rate risk relates to what the basic cash flows will be worth in the
parent company’s home currency. The foreign currency cash flows to be turned
over to the parent must be converted into U.S. dollars by translating them at
expected future exchange rates. An analysis should be conducted to ascertain the
effects of exchange rate variations, and, on the basis of this analysis, an exchange
rate risk premium should be added to the domestic cost of capital to reflect exchange rate risk. It is sometimes possible to hedge against exchange rate fluctuations, but it may not be possible to hedge completely, especially on long-term
projects. If hedging is used, the costs of doing so must be subtracted from the
project’s cash flows.
Political risk refers to potential actions by a host government which would
reduce the value of a company’s investment. It includes at one extreme the expropriation without compensation of the subsidiary’s assets, but it also includes
less drastic actions that reduce the value of the parent firm’s investment in the
foreign subsidiary, including higher taxes, tighter repatriation or currency controls, and restrictions on prices charged. The risk of expropriation is small in
traditionally friendly and stable countries such as Great Britain or Switzerland.
However, in Latin America, Africa, the Far East, and Eastern Europe, the risk
may be substantial. Past expropriations include those of ITT and Anaconda Copper in Chile, Gulf Oil in Bolivia, Occidental Petroleum in Libya, Enron Corporation in Peru, and the assets of many companies in Iraq, Iran, and Cuba.
Several organizations rate the political risk of countries. For example, International Business Communications, a London company, publishes the International Country Risk Guide, which contains individual ratings for political, financial, and economic risk, along with a composite rating for each country. Table
18-4 contains selected portions of a recent report. The political variable — which
makes up 50 percent of the composite rating — includes factors such as government corruption and the gap between economic expectations and reality. The
Selecte d Count ries Ranke d by Composit e Risk
RANK
COUNTRY
POLITICAL
RISK
FINANCIAL
RISK
ECONOMIC
RISK
COMPOSITE
RISK
1
Switzerland
93.0
50.0
39.5
91.5
9
United States
78.0
49.0
39.5
83.5
10
Canada
81.0
48.0
37.0
83.0
25
Venezuela
75.0
40.0
36.0
75.5
50
Israel
58.0
33.0
34.5
63.0
75
Panama
47.0
24.0
38.0
54.5
100
Peru
45.0
28.0
21.5
47.5
125
Burma
27.0
9.0
22.5
28.5
129
Liberia
10.0
8.0
12.0
15.0
NOTE: A total of 129 countries are ranked, but only 9 are shown here.
SOURCE: International Country Risk Guide.
%%FF148026_724
724
CHAPTER 18
MULTINATIONAL FINANCIAL MANAGEMENT
financial rating looks at such things as the likelihood of losses from exchange
controls and loan defaults. The economic rating takes into account such factors
as inflation and debt-service costs.
The best, or least risky, score is 100 for political factors and 50 each for the
financial and economic factors, and the composite risk is a weighted average of
the political, financial, and economic factors. The United States is ranked ninth,
below Switzerland, Luxembourg, Norway, Austria, Germany, Netherlands, Brunei,
and Japan. Liberia, as shown in Table 18-4, is ranked last.
If a company’s management has a serious concern that a given country might
expropriate foreign assets, it will probably not make significant investments in
that country. However, companies can take steps to reduce the potential loss from
expropriation in three major ways: (1) finance the subsidiary with local capital,
(2) structure operations so that the subsidiary has value only as a part of the
integrated corporate system, and (3) obtain insurance against economic losses
from expropriation from a source such as the Overseas Private Investment Corporation (OPIC). In the latter case, insurance premiums would have to be added
to the project’s cost.
SELF-TEST QUESTIONS
List some key differences in capital budgeting as applied to foreign versus domestic operations.
What are the relevant cash flows for an international investment?
Why might the cost of capital for a foreign project differ from that of an equivalent domestic project? Could it be lower?
What adjustments might be made to the domestic cost of capital for a foreign
investment due to exchange rate risk and political risk?
INTERNATIONAL CAPITAL STRUCTURES
Slide 18-27
Companies’ capital structures vary among the large industrial countries. For example, the Organization for Economic Cooperation and Development (OECD) recently reported that, on average, Japanese firms use 85 percent debt to total assets (in book value terms), German firms use 64 percent, and U.S. firms use 55
percent. One problem, however, when interpreting these numbers is that different countries often use very different accounting conventions with regard to
(1) reporting assets on a historical- versus a replacement-cost basis, (2) the treatment of leased assets, (3) pension plan funding, and (4) capitalizing versus expensing R&D costs. These differences make it difficult to compare capital
structures.
One recent study, by Raghuram Rajan and Luigi Zingales of the University of
Chicago, attempts to control for differences in accounting practices. In their
study, Rajan and Zingales used a database which covers fewer firms than the
OECD but which provides a more complete breakdown of balance sheet data.
Rajan and Zingales concluded that differences in accounting practices can
explain much of the cross-country variation in capital structures.
Rajan’s and Zingales’ results are summarized in Table 18-5. There are a number of different ways to measure capital structure. One measure is the average
ratio of total liabilities to total assets — this is similar to the measure used by
%%FF148026_725
INTERNATIONAL CAPITAL STRUCTURES
T A B L E
725
Median Ca pit al St ruc t ure s among Large I ndust rializ e d
Countries (Me a sured in Te rms of Book Va lue )
1 8 - 5
TOTAL
LIABILITIES TO
TOTAL ASSETS
TOTAL
LIABILITIES TO
TOTAL ASSETS
(ADJUSTED FOR
DIFFERENCES IN
DEBT TO TOTAL
ASSETS
(UNADJUSTED FOR
DIFFERENCES IN
DEBT TO TOTAL
ASSETS
(ADJUSTED FOR
ACCOUNTING
ACCOUNTING
ACCOUNTING
ACCOUNTING
(UNADJUSTED FOR
DIFFERENCES)
DIFFERENCES)
DIFFERENCES)
DIFFERENCES)
COUNTRY
(1)
(2)
(3)
(4)
TIMES INTEREST
EARNED (TIE)
RATIO
(5)
Canada
56%
32%
48%
32%
1.553
France
71
25
69
18
2.64
Germany
73
16
50
11
3.20
Italy
70
27
68
21
1.81
Japan
69
35
62
21
2.46
United Kingdom
54
18
47
10
4.79
United States
58
27
52
25
2.41
Mean
64.4%
25.7%
56.6%
19.7%
2.693
Standard
deviation
8.1%
6.9%
9.5%
7.7%
1.073
SOURCE: Raghuram Rajan and Luigi Zingales: “What Do We Know about Capital Structure? Some Evidence from International Data,” The Journal
of Finance, Vol. 50, No. 5, December 1995, 1421–1460. Used with permission.
the OECD, and it is reported in column 1. Based on this measure, German and
Japanese firms appear to be more highly levered than U.S. firms. However, if you
look at column 2, where capital structure is measured by interest-bearing debt
to total assets, it appears that German firms use less leverage than U.S. and Japanese firms. What explains this difference? Rajan and Zingales argue that much of
this difference is explained by the way German firms account for pension liabilities. German firms generally include all pension liabilities (and their offsetting
assets) on the balance sheet, whereas firms in other countries (including the
United States) generally “net out” pension assets and liabilities on their balance
sheets. To see the importance of this difference, consider a firm with $10 million
in liabilities (not including pension liabilities) and $20 million in assets (not including pension assets). Assume that the firm has $10 million in pension liabilities which are fully funded by $10 million in pension assets. Therefore, net pension liabilities are zero. If this firm were in the United States, it would report a
ratio of total liabilities to total assets equal to 50 percent ($10 million/$20 million). By contrast, if this firm operated in Germany, both its pension assets and
liabilities would be reported on the balance sheet. The firm would have $20 million in liabilities and $30 million in assets — or a 67 percent ($20 million/$30
million) ratio of total liabilities to total assets. Total debt is the sum of shortterm debt and long-term debt and excludes other liabilities including pension
liabilities. Therefore, the measure of total debt to total assets provides a more
comparable measure of leverage across different countries.
Rajan and Zingales also make a variety of adjustments which attempt to control for other differences in accounting practices. The effect of these adjustments
are reported in Columns 3 and 4. Overall, the evidence suggests that companies
in Germany and the United Kingdom tend to have less leverage, whereas firms
%%FF148026_726
726
CHAPTER 18
MULTINATIONAL FINANCIAL MANAGEMENT
in Canada appear to have more leverage, relative to firms in the United States,
France, Italy, and Japan. This conclusion is supported by data in the final column, which shows the average times-interest-earned ratio for firms in a number
of different countries. Recall from Chapter 3 that the times-interest-earned ratio
is the ratio of operating income (EBIT) to interest expense. This measure indicates how much cash the firm has available to service its interest expense. In
general, firms with more leverage have a lower times-interest-earned ratio. The
data indicate that this ratio is highest in the United Kingdom and Germany and
lowest in Canada.
SELF-TEST QUESTION
Do international differences in financial leverage exist? Explain.
MULTINATIONAL WORKING
CAPITAL MANAGEMENT
CASH MANAGEMENT
Slide 18-28
Slide 18-29
The goals of cash management in a multinational corporation are similar to those
in a purely domestic corporation: (1) to speed up collections, slow down disbursements, and thus maximize net float; (2) to shift cash as rapidly as possible from
those parts of the business where it is not needed to those parts where it is needed;
and (3) to maximize the risk-adjusted, after-tax rate of return on temporary cash
balances. Multinational companies use the same general procedures for achieving these goals as domestic firms, but because of longer distances and more serious mail delays, such devices as lockbox systems and electronic funds transfers
are especially important.
Although multinational and domestic corporations have the same objectives
and use similar procedures, multinational corporations face a far more complex
task. As noted earlier in our discussion of political risk, foreign governments often place restrictions on transfers of funds out of the country, so although IBM
can transfer money from its Salt Lake City office to its New York concentration
bank just by pressing a few buttons, a similar transfer from its Buenos Aires office is far more complex. Buenos Aires funds are denominated in australs (Argentina’s equivalent of the dollar), so the australs must be converted to dollars
before the transfer. If there is a shortage of dollars in Argentina, or if the Argentinean government wants to conserve dollars to purchase strategic materials, then
conversion, hence the transfer, may be blocked. Even if no dollar shortage exists
in Argentina, the government may still restrict funds outflows if those funds represent profits or depreciation rather than payments for purchased materials or
equipment, because many countries, especially those that are less developed, want
profits reinvested in the country in order to stimulate economic growth.
Once it has been determined what funds can be transferred, the next task is
to get those funds to locations where they will earn the highest returns. Whereas
domestic corporations tend to think in terms of domestic securities, multinationals are more likely to be aware of investment opportunities all around the
world. Most multinational corporations use one or more global concentration
banks, located in money centers such as London, New York, Tokyo, Zurich, or
Singapore, and their staffs in those cities, working with international bankers,
%%FF148026_727
MULTINATIONAL WORKING CAPITAL MANAGEMENT
727
know of and are able to take advantage of the best rates available anywhere in
the world.
CREDIT MANAGEMENT
Slide 18-30
LECTURE NOTE
Collecting on accounts receivable
that are late is much more difficult when the customer is in a
foreign country. This is one reason for the use of bankers’ acceptances and other payment methods that are guaranteed.
Like most other aspects of finance, credit management in the multinational corporation is similar to but more complex than that in a purely domestic business.
First, granting credit is more risky in an international context because, in addition to the normal risks of default, the multinational corporation must also worry
about exchange rate fluctuations between the time a sale is made and the time a
receivable is collected. For example, if IBM sold a computer to a Japanese customer for 90 million yen when the exchange rate was 90 yen to the dollar, IBM
would obtain 90,000,000/90 5 $1,000,000 for the computer. However, if it sold
the computer on terms of net/6 months, and if the yen fell against the dollar so
that one dollar would now buy 112.5 yen, IBM would end up realizing only
90,000,000/112.5 5 $800,000 when it collected the receivable. Hedging can reduce this type of risk, but at a cost.
Offering credit is generally more important for multinational corporations
than for purely domestic firms for two reasons. First, much U.S. trade is with
poorer, less developed nations, where granting credit is generally a necessary condition for doing business. Second, and in large part as a result of the first point,
developed nations whose economic health depends on exports often help their
manufacturing firms compete internationally by granting credit to foreign countries. In Japan, for example, the major manufacturing firms have direct ownership ties with large “trading companies” engaged in international trade, as well
as with giant commercial banks. In addition, a government agency, the Ministry
of International Trade and Industry (MITI), helps Japanese firms identify potential export markets and also helps potential customers arrange credit for purchases from Japanese firms. In effect, the huge Japanese trade surpluses are used
to finance Japanese exports, thus helping to perpetuate their favorable trade balance. The United States has attempted to counter with the Export-Import Bank,
which is funded by Congress, but the fact that the United States has a large balance of payments deficit is clear evidence that we have been less successful than
others in world markets in recent years.
The huge debt which countries such as Brazil, Mexico, and Argentina owe U.S.
and other international banks is well known, and this situation illustrates how
credit policy (by banks in this case) can go astray. The banks face a particularly
sticky problem with these loans, because if a sovereign nation defaults, the banks
cannot lay claim to the assets of the country as they could if a corporate customer defaulted. Note too that although the banks’ loans to foreign governments
are getting most of the headlines, many U.S. multinational corporations are also
in trouble as a result of granting credit to business customers in the same countries where bank loans to governments are on shaky ground.
By pointing out the risks in granting credit internationally, we are not suggesting that such credit is bad. Quite the contrary, for the potential gains from
international operations far outweigh the risks, at least for companies (and banks)
that have the necessary expertise.
INVENTORY MANAGEMENT
Slide 18-31
As with most other aspects of finance, inventory management in a multinational
setting is similar to but more complex than for a purely domestic firm. First,
%%FF148026_728
728
CHAPTER 18
MULTINATIONAL FINANCIAL MANAGEMENT
there is the matter of the physical location of inventories. For example, where
should Exxon keep its stockpiles of crude oil and refined products? It has refineries and marketing centers located worldwide, and one alternative is to keep
items concentrated in a few strategic spots from which they can then be shipped
as needs arise. Such a strategy might minimize the total amount of inventories
needed and thus might minimize the investment in inventories. Note, though,
that consideration will have to be given to potential delays in getting goods from
central storage locations to user locations all around the world. Both working
stocks and safety stocks would have to be maintained at each user location, as
well as at the strategic storage centers. Problems like the Iraqi occupation of Kuwait and the subsequent trade embargo, which brought with it the potential for
a shutdown of production of about 25 percent of the world’s oil supply, complicate matters further.
Exchange rates also influence inventory policy. If a local currency, say, the
Danish krone, were expected to rise in value against the dollar, a U.S. company
operating in Denmark would want to increase stocks of local products before the
rise in the krone, and vice versa if the krone were expected to fall.
Another factor that must be considered is the possibility of import or export
quotas or tariffs. For example, Apple Computer Company was buying certain
memory chips from Japanese suppliers at a bargain price. Then U.S. chipmakers
accused the Japanese of dumping chips in the U.S. market at prices below cost,
so they sought to force the Japanese to raise prices. That led Apple to increase its
chip inventory.6 Then computer sales slacked off, and Apple ended up with an
oversupply of obsolete computer chips. As a result, Apple’s profits were hurt and
its stock price fell, demonstrating once more the importance of careful inventory
management.
As mentioned earlier, another danger in certain countries is the threat of expropriation. If that threat is large, inventory holdings will be minimized, and
goods will be brought in only as needed. Similarly, if the operation involves extraction of raw materials such as oil or bauxite, processing plants may be moved
offshore rather than located close to the production site.
Taxes have two effects on multinational inventory management. First, countries often impose property taxes on assets, including inventories, and when this
is done, the tax is based on holdings as of a specific date, say, January 1 or March
1. Such rules make it advantageous for a multinational firm (1) to schedule production so that inventories are low on the assessment date, and (2) if assessment
dates vary among countries in a region, to hold safety stocks in different countries at different times during the year.
Finally, multinational firms may consider the possibility of at-sea storage. Oil,
chemical, grain, and other companies that deal in a bulk commodity that must
be stored in some type of tank can often buy tankers at a cost not much
greater — or perhaps even less, considering land cost — than land-based facilities.
6
The term “dumping” warrants explanation, because the practice is so potentially important in international markets. Suppose Japanese chipmakers have excess capacity. A particular chip has a variable
cost of $25, and its “fully allocated cost,” which is the $25 plus total fixed cost per unit of output, is
$40. Now suppose the Japanese firm can sell chips in the United States at $35 per unit, but if it
charges $40, it will not make any sales because U.S. chipmakers sell for $35.50. If the Japanese firm
sells at $35, it will cover variable cost plus make a contribution to fixed overhead, so selling at $35
makes sense. Continuing, if the Japanese firm can sell in Japan at $40, but U.S. firms are excluded
from Japanese markets by import duties or other barriers, the Japanese will have a huge advantage
over U.S. manufacturers. This practice of selling goods at lower prices in foreign markets than at
home is called “dumping.” U.S. firms are required by antitrust laws to offer the same price to all
customers and, therefore, cannot engage in dumping.
%%FF148026_729
SUMMARY
729
Loaded tankers can then be kept at sea or at anchor in some strategic location.
This eliminates the danger of expropriation, minimizes the property tax problem, and maximizes flexibility with regard to shipping to areas where needs are
greatest or prices highest.
This discussion has only scratched the surface of inventory management in
the multinational corporation — the task is much more complex than for a purely
domestic firm. However, the greater the degree of complexity, the greater the
rewards from superior performance, so if you want challenge along with potentially high rewards, look to the international arena.
SELF-TEST QUESTIONS
What are some factors that make cash management especially complicated in
a multinational corporation?
Why is granting credit especially risky in an international context?
Why is credit policy especially important for a multinational firm?
SUMMARY
This chapter discussed the most important differences between multinational and
domestic financial management. Some of the key concepts are listed below:
♦ International operations are becoming increasingly important to individual
firms and to the national economy. A multinational, or global, corporation is
a firm that operates in an integrated fashion in a number of countries.
♦ Companies “go global” for six primary reasons: (1) to expand their markets,
(2) to obtain raw materials, (3) to seek new technology, (4) to lower production costs, (5) to avoid trade barriers, and (6) to diversify.
♦ Six major factors distinguish financial management as practiced by domestic
firms from that practiced by multinational corporations: (1) different currency
denominations, (2) different economic and legal structures, (3) languages, (4)
cultural differences, (5) role of governments, and (6) political risk.
♦ When discussing exchange rates, the number of U.S. dollars required to purchase one unit of a foreign currency is called a direct quotation, while the
number of units of foreign currency that can be purchased for one U.S. dollar
is an indirect quotation.
♦ Financial forecasting is more difficult for multinational firms, because
exchange rate fluctuations make it difficult to estimate the dollars that overseas operations will produce.
♦ Prior to August 1971, the world was on a fixed exchange rate system whereby
the U.S. dollar was linked to gold and other currencies were then tied to the
dollar. After August 1971, the world monetary system changed to a floating
system under which major world currency rates float with market forces,
largely unrestricted by governmental intervention. The central bank of each
country does operate in the foreign exchange market, buying and selling currencies to smooth out exchange rate fluctuations, but only to a limited extent.
♦ Pegged exchange rates occur when a country establishes a fixed exchange rate
with a major currency. Consequently, the values of pegged currencies move
together over time.
%%FF148026_730
730
CHAPTER 18
MULTINATIONAL FINANCIAL MANAGEMENT
♦ Spot rates are the rates paid for delivery of currency “on the spot,” while the
forward exchange rate is the rate paid for delivery at some agreed-upon future
date, usually 30, 90, or 180 days from the day the transaction is negotiated.
The forward rate can be at either a premium or a discount to the spot rate.
♦ Interest rate parity holds that investors should expect to earn the same return
in all countries after adjusting for risk.
♦ Purchasing power parity, sometimes referred to as the law of one price, implies that the level of exchange rates adjusts so that identical goods cost the
same in different countries.
♦ Granting credit is more risky in an international context because, in addition
to the normal risks of default, the multinational firm must worry about exchange rate changes between the time a sale is made and the time a receivable is collected.
♦ Credit policy is important for a multinational firm for two reasons: (1) Much
trade is with less-developed nations, and in such situations granting credit is
a necessary condition for doing business. (2) The governments of nations such
as Japan whose economic health depends upon exports often help their firms
compete by granting credit to foreign customers.
♦ Foreign investments are similar to domestic investments, but political risk and
exchange rate risk must be considered. Political risk is the risk that the foreign government will take some action which will decrease the value of the
investment, while exchange rate risk is the risk of losses due to fluctuations
in the value of the dollar relative to the values of foreign currencies.
♦ Investments in international capital projects expose firms to exchange rate risk
and political risk. The relevant cash flows in international capital budgeting
are the dollars which can be turned over to the parent company.
♦ Eurodollars are U.S. dollars deposited in banks outside the United States. Interest rates on Eurodollars are tied to LIBOR, the London interbank offer rate.
♦ U.S. firms often find that they can raise long-term capital at a lower cost outside the United States by selling bonds in the international capital markets.
International bonds may be either foreign bonds, which are exactly like regular domestic bonds except that the issuer is a foreign company, or Eurobonds,
which are bonds sold in a foreign country but denominated in the currency of
the issuing company’s home country.
QUESTIONS
18-1
18-2
18-3
18-4
18-5
18-6
Under the fixed exchange rate system, what was the currency against which all other currency values were defined? Why?
Exchange rates fluctuate under both the fixed exchange rate and floating exchange rate
systems. What, then, is the difference between the two systems?
If the French franc depreciates against the U.S. dollar, can a dollar buy more or fewer
French francs as a result?
If the United States imports more goods from abroad than it exports, foreigners will tend
to have a surplus of U.S. dollars. What will this do to the value of the dollar with respect
to foreign currencies? What is the corresponding effect on foreign investments in the
United States?
Why do U.S. corporations build manufacturing plants abroad when they could build them
at home?
Should firms require higher rates of return on foreign projects than on identical projects
located at home? Explain.
%%FF148026_731
QUESTIONS/PROBLEMS
18-7
18-8
18-9
731
What is a Eurodollar? If a French citizen deposits $10,000 in Chase Manhattan Bank in
New York, have Eurodollars been created? What if the deposit is made in Barclay’s Bank
in London? Chase Manhattan’s Paris branch? Does the existence of the Eurodollar market
make the Federal Reserve’s job of controlling U.S. interest rates easier or more difficult?
Explain.
Does interest rate parity imply that interest rates are the same in all countries?
Why might purchasing power parity fail to hold?
SELF-TEST PROBLEM
ST-1
Key terms
Define each of the following terms:
a. Multinational corporation
b. Exchange rate
c. Fixed exchange rate system; floating exchange rates
d. Trade deficit
e. Devaluation; revaluation
f. Exchange rate risk; convertible currency
g. Pegged exchange rates
h. Interest rate parity; purchasing power parity
i. Spot rate; forward exchange rate
j. Discount on forward rate; premium on forward rate
k. Repatriation of earnings; political risk
l. Eurodollar; Eurobond; international bond; foreign bond
m. European currency units (ECUs); Eurocurrencies
STARTER PROBLEMS
18-1
Cross rates
18-2
Interest rate parity
18-3
Purchasing power parity
A currency trader observes that in the spot exchange market, one U.S. dollar can be exchanged for 1,498.2 Italian lira or for 111.23 Japanese yen. What is the cross-exchange
rate between the yen and the lira; that is, how many yen would you receive for every lira
exchanged?
Six-month T-bills have a nominal rate of 7 percent, while default-free Japanese bonds that
mature in 6 months have a nominal rate of 5.5 percent. In the spot exchange market, one
yen equals $0.009. If interest rate parity holds, what is the 6-month forward exchange rate?
A television set costs $500 in the United States. The same set costs 2,535 French francs. If
purchasing power parity holds, what is the spot exchange rate between the franc and the
dollar?
EXAM-TYPE PROBLEMS
18-4
Exchange rate
18-5
Currency appreciation
18-6
Cross exchange rates
18-7
Cross exchange rates
18-8
Foreign investment analysis
The problems included in this section are set up in such a way that they could be used
as multiple-choice exam problems.
If British pounds sell for $1.50 (U.S.) per pound, what should dollars sell for in pounds
per dollar?
Suppose that 1 French franc could be purchased in the foreign exchange market for 20
U.S. cents today. If the franc appreciated 10 percent tomorrow against the dollar, how
many francs would a dollar buy tomorrow?
Suppose the exchange rate between U.S. dollars and the French franc was FF5.9 5 $1,
and the exchange rate between the dollar and the British pound was £1 5 $1.50. What
was the exchange rate between francs and pounds?
Look up the 3 currencies in Problem 18-6 in the foreign exchange section of a current
issue of The Wall Street Journal. What is the current exchange rate between francs and
pounds?
After all foreign and U.S. taxes, a U.S. corporation expects to receive 3 pounds of dividends per share from a British subsidiary this year. The exchange rate at the end of the
year is expected to be $1.60 per pound, and the pound is expected to depreciate 5 percent
against the dollar each year for an indefinite period. The dividend (in pounds) is expected
to grow at 10 percent a year indefinitely. The parent U.S. corporation owns 10 million
%%FF148026_732
732
CHAPTER 18
MULTINATIONAL FINANCIAL MANAGEMENT
18-9
Exchange gains and losses
shares of the subsidiary. What is the present value in dollars of its equity ownership of the
subsidiary? Assume a cost of equity capital of 15 percent for the subsidiary.
You are the vice-president of International InfoXchange, headquartered in Chicago, Illinois. All shareholders of the firm live in the United States. Earlier this month, you obtained a loan of 5 million Canadian dollars from a bank in Toronto to finance the construction of a new plant in Montreal. At the time the loan was received, the exchange rate
was 75 U.S. cents to the Canadian dollar. By the end of the month, it has unexpectedly
dropped to 70 cents. Has your company made a gain or loss as a result, and by how much?
PROBLEMS
18-10
Exchange rates
18-11
Exchange rates
18-12
Results of exchange rate changes
18-13
Spot and forward rates
18-14
Interest rate parity
18-15
Interest rate parity
18-16
Purchasing power parity
18-17
Purchasing power parity
Table 18-1 lists foreign exchange rates for December 19, 1996. On that day, how many
dollars would be required to purchase 1,000 units of each of the following: German marks,
Italian lira, Japanese yen, Mexican pesos, and Swiss francs?
Look up the 5 currencies in Problem 18-10 in the foreign exchange section of a current
issue of The Wall Street Journal.
a. What is the current exchange rate for changing dollars into 1,000 units of marks, lira,
yen, pesos, and Swiss francs?
b. What is the percentage gain or loss between the December 19, 1996, exchange rate
and the current exchange rate for each of the currencies in Part a?
Early in September 1983, it took 245 Japanese yen to equal $1. More than 13 years later,
in December 1996, that exchange rate had fallen to 114 yen to $1. Assume the price of a
Japanese-manufactured automobile was $8,000 in September 1983 and that its price
changes were in direct relation to exchange rates.
a. Has the price, in dollars, of the automobile increased or decreased during the 13-year
period because of changes in the exchange rate?
b. What would the dollar price of the automobile be on December 19, 1996, again assuming that the car’s price changes only with exchange rates?
Boisjoly French Imports has agreed to purchase 15,000 cases of French wine for 16 million francs at today’s spot rate. The firm’s financial manager, James Desreumaux, has noted
the following current spot and forward rates:
U.S. DOLLAR/FRANC
FRANC/U.S. DOLLAR
Spot
0.16933
5.9055
30-day forward
0.16890
5.9207
90-day forward
0.16807
5.9499
180-day forward
0.16719
5.9812
On the same day, Desreumaux agrees to purchase 15,000 more cases of wine in 3 months
at the same price of 16 million francs.
a. What is the price of the wine, in U.S. dollars, if it is purchased at today’s spot rate?
b. What is the cost, in dollars, of the second 15,000 cases if payment is made in 90 days
and the spot rate at that time equals today’s 90-day forward rate?
c. If the exchange rate for the French franc is 5.00 to $1 in 90 days, how much will he
have to pay for the wine (in dollars)?
Assume that interest rate parity holds and that 90-day risk-free securities yield 5 percent in
the United States and 5.3 percent in Germany. In the spot market 1 mark equals 0.63 dollar.
a. Is the 90-day forward rate trading at a premium or discount relative to the spot rate?
b. What is the 90-day forward rate?
Assume that interest rate parity holds. In both the spot market and the 90-day forward
market 1 Japanese yen equals 0.0086 dollar. The 90-day risk-free securities yield 4.6 percent in Japan. What is the yield on 90-day risk-free securities in the United States?
In the spot market 7.8 pesos can be exchanged for 1 U.S. dollar. A compact disk costs $15
in the United States. If purchasing power parity holds, what should be the price of the
same disk in Mexico?
A chair costs 500 French francs. The same chair also costs 10,000 Japanese yen. If purchasing power parity holds, what should be the exchange rate between the yen and the
French franc?
%%FF148026_733
QUESTIONS/PROBLEMS
II
N
N
TT
E
E
G
G
R
R
A
A
CITRUS PRODUCTS INC.
18-18 Multinational Financial Management Citrus Products
Inc. is a medium-sized producer of citrus juice drinks with
groves in Indian River County, Florida. Until now, the company has confined its operations and sales to the United States,
but its CEO, George Gaynor, wants to expand into Europe. The
first step would be to set up sales subsidiaries in Spain and
Portugal, then to set up a production plant in Spain, and, finally, to distribute the product throughout the European common market. The firm’s financial manager, Ruth Schmidt, is
enthusiastic about the plan, but she is worried about the implications of the foreign expansion on the firm’s financial management process. She has asked you, the firm’s most recently
hired financial analyst, to develop a 1-hour tutorial package
that explains the basics of multinational financial management. The tutorial will be presented at the next board of directors meeting. To get you started, Schmidt has supplied you
with the following list of questions.
a. What is a multinational corporation? Why do firms expand
into other countries?
b. What are the six major factors which distinguish multinational financial management from financial management
as practiced by a purely domestic firm?
c. Consider the following illustrative exchange rates.
U.S. DOLLARS REQUIRED TO BUY
ONE UNIT OF FOREIGN CURRENCY
Spanish peseta
0.0075
Portuguese escudo
0.0063
(1) Are these currency prices direct quotations or indirect
quotations?
(2) Calculate the indirect quotations for pesetas and
escudos.
(3) What is a cross rate? Calculate the two cross rates between pesetas and escudos.
(4) Assume Citrus Products can produce a liter of orange
TT
E
E
D
D
C
C
A
A
S
S
733
E
E
juice and ship it to Spain for $1.75. If the firm wants a
50 percent markup on the product, what should the
orange juice sell for in Spain?
(5) Now, assume Citrus Products begins producing the
same liter of orange juice in Spain. The product costs
200 pesetas to produce and ship to Portugal, where it
can be sold for 400 escudos. What is the dollar profit
on the sale?
(6) What is exchange rate risk?
d. Briefly describe the current international monetary system.
How does the current system differ from the system that
was in place prior to August 1971?
e. What is a convertible currency? What problems arise when
a multinational company operates in a country whose currency is not convertible?
f. What is the difference between spot rates and forward rates?
When is the forward rate at a premium to the spot rate? At
a discount?
g. What is interest rate parity? Currently, you can exchange 1
peseta for 0.0080 dollar in the 30-day forward market, and
the risk-free rate on 30-day securities is 4 percent in both
Spain and the United States. Does interest rate parity hold?
If not, which securities offer the highest expected return?
h. What is purchasing power parity? If grapefruit juice costs
$2.00 a liter in the United States and purchasing power parity holds, what should be the price of grapefruit juice in
Portugal?
i. What impact does relative inflation have on interest rates
and exchange rates?
j. Briefly discuss the international capital markets.
k. To what extent do average capital structures vary across different countries?
l. What is the impact of multinational operations on each of
the following financial management topics?
(1) Cash management.
(2) Capital budgeting decisions.
(3) Credit management.
(4) Inventory management.